A Coverdell education savings account is a type of custodial account designed to help save and pay for qualifying education expenses. While Coverdell ESAs are similar to a 529 plan, there are also some differences in how they can help you save for your child’s college education.
If you’re planning to save for college and want to use a Coverdell ESA, make sure you know all the rules before setting one up.
What is a Coverdell education savings account?
A Coverdell education savings account, or Coverdell ESA, is a savings plan made for education-related expenses, whether that’s for college, elementary or secondary education.
Like a 529 college savings plan, a Coverdell ESA offers some tax benefits, which you won’t get with a brokerage account or traditional savings account. However, there are also some differences — both advantages and disadvantages — to keep in mind.
For example, Coverdell ESAs allow you to choose the specific investments you’d like the money to go toward. If you have a 529 plan, you don’t have the same freedom to choose any investment for your account. That said, you’re more limited on when and how much you can contribute to a Coverdell ESA.
How does a Coverdell education savings account work?
You can create a Coverdell ESA for a beneficiary, typically your child, who is under the age of 18. You can contribute up to $2,000 per year until your child has reached the age of 18 — though beneficiaries with special needs get an exception.
That limit is phased out if your modified adjusted gross income (MAGI) is between $95,000 and $110,000 (or between $190,000 and $220,000 for joint filers). If your MAGI is more than $110,000 (or $220,000 if you’re filing jointly), you can’t make any contributions at all.
As you invest your contributions, they’ll grow on a tax-deferred basis. Once your child is enrolled in school, you can take Coverdell education savings account withdrawals to cover qualifying education expenses tax-free. Qualified expenses include tuition, books, equipment, academic tutoring and even special needs services.
In addition to college expenses, you can also cover eligible K-12 expenses. With a 529 plan, eligible K-12 expenses are limited to tuition, and there’s a $10,000 cap.
If you have unused funds in a Coverdell ESA, they must be used or rolled over into another ESA or a 529 plan by the time the beneficiary reaches the age of 30 — or you can change the beneficiary on the existing account. If you withdraw funds for purposes other than qualifying education expenses, the distributions will be taxed.
Pros and cons of a Coverdell education savings account
There are several reasons to consider opening a Coverdell ESA, but there are also some drawbacks to keep in mind.
- You’ll have more control over your investment options than with a 529 plan.
- Funds can be used for both K-12 and college expenses.
- Contributions grow and can be withdrawn tax-free for qualified expenses.
- You can only contribute up to $2,000 per year, and households with a higher income are excluded entirely.
- You can no longer contribute after your child has turned 18.
- You’ll need to use the funds, roll them over to another ESA with a different beneficiary or a 529 plan, or change the beneficiary by the time your original beneficiary turns 30.
Who should invest in an education savings account?
A Coverdell ESA isn’t for everyone. Considering the benefits and the drawbacks, here are some situations where it might make sense to use a Coverdell ESA instead of a 529 plan or some other savings account:
- You never plan to contribute more than $2,000 per year.
- Your MAGI is below the phaseout threshold.
- You don’t plan to make contributions after your child turns 18.
- You live in a state that doesn’t offer additional tax benefits for 529 plan contributions.
- You want to save for K-12 education expenses without limitations.
Consider your situation and compare all of your options before you decide which one to use to save for your child’s college education.
Coverdell education savings account withdrawal and contribution rules
A Coverdell ESA has specific contribution and withdrawal requirements. If you want to avoid taxes, here’s what you need to know.
- The account limits contributions to $2,000 annually. Additional contributions are subject to a 6 percent excise tax annually.
- Your modified adjusted gross income could limit how much you contribute (or if you can contribute at all).
- Contributions can be made only until the beneficiary turns 18 unless the beneficiary has special needs. After that, any contribution you make will be subject to the 6 percent excise tax every year.
- Funds must be used for qualified education expenses, from elementary all the way up through college, or else you’ll face a 10 percent tax penalty, plus income taxes on the gains.
- Any money left after the beneficiary turns 30 must be withdrawn within 30 days of their birthday unless the beneficiary has special needs.
What are the tax implications of a Coverdell education savings account?
Contributions to Coverdell accounts aren’t tax deductible, but the earnings you gain on your investment grow on a tax-deferred basis. If your Coverdell education savings account withdrawals are for qualified education expenses, you won’t owe any taxes on them.
But any distributions you take beyond what’s qualified will be subject to a 10 percent penalty, plus ordinary income taxes on the portion of your withdrawal that can be attributed to your gains.
For example, if you contributed $5,000 and gained $15,000, only 75 percent of a nonqualified withdrawal will be taxable.
If you exceed the $2,000 annual contribution limit or put money in the account after your child reaches 18 years old — and they don’t have special needs — you’ll owe a 6 percent tax on those excess contributions each year that they remain in the account.
Also, the beneficiary only has until age 30 to use Coverdell ESA funds. Once they reach 30 years of age, the remaining account funds will be subject to a 10 percent penalty and income taxes on the gains unless the beneficiary has special needs, you roll over the funds to a Coverdell ESA with a younger beneficiary, you roll over funds to a 529 plan or you change the beneficiary on the existing account.
What happens to unused ESA funds?
There’s a chance that you may not use all the funds in your Coverdell ESA account. However, the account requires that you use up all the funds by the time the beneficiary reaches age 30 unless they have special needs.
If you have money left over after your child completes their education, you have two options:
- Roll it over: You can roll over unused Coverdell money to another account for an eligible family member, or you can change the beneficiary for the current account. You can also transfer it to a 529 plan, which is a qualified distribution, to avoid the tax penalty.
- Withdraw it: The funds need to be withdrawn within 30 days of the beneficiary’s 30th birthday. Whether you use the money for qualifying education expenses or not, you’ll need to take it out of the account or risk losing it. If your distribution is not for qualified education expenses, plan to set aside some money for the 10 percent penalty and income taxes.
The bottom line
While a Coverdell ESA is one college savings option, it’s not your only option. Before you choose a Coverdell account, make sure that you qualify to open and contribute to one first. You can open up a Coverdell ESA with any brokerage or investment firm that offers them.
Compare your options to determine the right fit for you. Additionally, you’ll want to look at other college savings plans, including 529 plans, a brokerage account or a savings account. In some cases, it may even be worth it to use more than one.